The Entryway – 2023 Year-End Review

What a difference a year makes

In 2023, investors were provided with a much-needed relief as the majority of asset classes staged a huge comeback off what was a historically bad year for virtually all asset prices in 2022. While 2023 turned out to be a phenomenal year for most investors, it was a surprise to most. As 2022 came to a close, most market participants and commentators felt that more pain may lie ahead in 2023 as the Fed was continuing to aggressively raise interest rates to battle inflation that was still stubbornly high and significantly above the Fed’s long-term inflation target. In fact, going into 2023 the consensus was that the US economy would enter a mild recession, interest rates would continue to rise for the foreseeable future, and inflation would stay sticky. As usual, most market commentators and their crystal balls proved to be wrong with inflation rapidly declining (from ~6.5% to start the year down to ~3.5%), the Fed choosing to pause interest rate hikes starting in July, and the economy proving to be incredibly resilient. These were welcome events for investors as they began to recover from their losses and proved yet again why it is so important to tactically shift asset allocation around specific needs and market environments, but not try to time getting in and out of markets.

At the end of 2023, here is where the major public market indices stood versus the 2022 market performance:

While these “top-line” numbers look strong, there are a couple items to highlight here. First, 2023 was not a broad market rally where most companies within a variety of economic sectors performed well. In fact, the top ten companies in the S&P 500, which includes the “Magnificent Seven,” accounted for ~85% of the total return of the S&P 500’s index return in 2023 and those 10 companies now make up more than 32% of the total market capitalization of the entire index.

Second, the earnings of the companies within the public markets, i.e the S&P 500, did not really grow. For instance, in 2023 the companies’ earnings within the S&P 500 were essentially flat with a wide disparity between the “Magnificent Seven” stocks (Apple, Microsoft, Alphabet, Amazon, Tesla, Meta & NVDA) versus the remainder of the index. On average the Magnificent Seven grew their earnings by 33% and the remaining 493 companies’ earnings declined 5% on average.

If earnings are not growing, markets only go higher if the number of investors who are willing to pay for those same earnings also goes up. At the end of 2023, the S&P 500’s forward 12-month price-to-earnings (P/E) ratio was 19.5x or ~20% higher than its 30-year average. In addition, the top 10 companies in the S&P 500 have a 12-month forward P/E ratio of 26.9x versus 17.1x for the remaining 490 companies within the S&P500.

While we are thrilled to see asset prices rise for our clients, we continue to critically analyze the concentration risk in the stock market, the elevated current valuations, and how the current interest rate policy of the Fed and economy may impact companies and their earnings.

Market Outlook: The Fed, the Economy, Inflation and Interest Rates

In 2023, the Fed raised interest rates by 0.25% in February, March, May, and July leaving the Federal Funds Rate in the 5.25% – 5.50% range. In addition, the U.S. Consumer Price Index (CPI) fell from ~6.5% in January and finished the year around 3.5%. Still interest rates are at the highest point they have been in more than 20 years, and inflation is still higher than the Fed would like. However, the fact that interest rates were held steady throughout the latter half of the year and the speed with which inflation is falling facilitated some much-needed visibility for future company operations and general optimism. In short, we may have tamed inflation and reached peak interest rates for this cycle.

As we always say, the market is a forward-looking machine that is pricing in what the world will look like in the next 9 – 12 months. In October, the Federal Reserve telegraphed their belief that we have likely reached peak interest rates and will likely see some interest rate cuts in 2024. Immediately, markets began rethinking how companies would perform with potentially cheaper cost of funds, how much more consumers may spend & borrow if rates moved down, and how many more people may be retained or hired as company sales and profitability grows. This was reflected in the stock market when the S&P 500 jumped +8.92% in November and +4.42% in December.

At the moment, the underlying economy within the United States is solid. We always borrow the famous Ray Dalio quote that says, “one person’s spending is another person’s income.” In other words, the overall Gross Domestic Product (GDP) in the United States is ~70% consumer spending, so the U.S. needs people to work, earn a good living, and purchase goods. At the end of 2023, the unemployment rate was 3.7% (versus 6.2% 50-year average), the year-over-year wage growth rate was 4.3% (versus 3.9% 50-year average), and the labor force participation rate for 25-54 years old was ~83.5% (the highest in more than 15 years). In other words, there are lots of people working and they have gotten a decent, fairly consistent pay raise over the past several years. However, the labor market is extremely dynamic and can shift quickly. The key to the consumer will be continued confidence in the business sector – that businesses can survive and thrive over the foreseeable future and much of that depends on interest rates.

In regard to interest rates and where they are headed, we believe the market may have gotten a little ahead of itself. The Fed has indicated that it may cut interest rates three times in 2024 whereas the market consensus is six cuts. The bottom line is that interest rate cuts or hikes will be data dependent on employment numbers, the inflation outlook, and the overall health of the economy. The answer will only be obvious in hindsight, but as investors we must continue to customize our asset allocation around our personal needs and stay invested in a variety of high-quality assets, such as stocks, bonds, cash, and alternative investments.

Lastly, we all know that 2024 is an election year. With any election year, there will be high emotions and varying debates on what is best for our country. From a historical perspective, who is in the White House has little impact on investment returns.

A Constant Reminder

Our clients may tire of us saying this, but the toughest part of investing is being patient, staying committed to your longer-term plan and ignoring the urge to “time the market.” One of our main jobs is to protect our families the best we can from market volatility and emotional mistakes. To that end, we spend much of our time listening, asking questions, to better understand your specific needs, and building a process around those needs. While it is never easy, there is great satisfaction and reward for those who are able to stay the course and consistently make logical decisions. We look forward to communicating and serving you in 2024 and beyond, and we will continue to look for new and creative ways to help you achieve your goals. We appreciate the trust you have put in us.